Friday, February 19, 2010

Firms aren't too big to fail, the sector is

When the financial crisis first started, I had a front row sit. As an investment analyst with a small financial advisor, it was my job (among many others) to keep an eye on the financial new and keep everyone appraised of what they had already read on Bloomberg. So when Bear Stern started giving signs of fading, (by which I mean screamed in agony) and JPMorgan started salivating at the smell of juicy interest obligations with low risk thanks to the Fed decided to altruistically help the Fed in rescuing the economy, I was able to start pondering the concept of "too big to fail."

My first reaction was: "Let them burn." Those were actually my words. I am a little bit of a libertarian and I tend to think that if a firm makes poor decisions over and over again, it should fail and allow other better firms to take over. At the very least, a lesson would be learned. I held on to that belief for quite a while and have not completely given up on it, but as times past by, I realized that 1) despite my grumbling, tax dollars were going to rescue those big banks and 2) I did not really want another Great Depression just to teach those guys a lesson.

Having given up on my insignificant campaign in the comments of financial blogs to advocate letting banks fail, I started joining the ranks of those who believed that at the very least, if you are too big to fail and you get rescued, part of the deal should be to make you small enough to fail next time. That felt very clever, but those words always left me with a bad after-taste which I ignored for quite some time.

Recently, I started thinking about the concept of too-big-to-fail within the context of the systemic risks and factors central to this crisis. (Now, many people will try to tell you that the crisis was due to greed, Clinton or Bush. Don't listen to them. In fact, if anyone claims to explain this financial crisis in less than a 10 page essay, they are either summarizing a very intelligent argument, an idiot or lying. Most likely, it is not the first.) The big culprits were poor loan origination practices which were focused on closing a deal no matter what the deal was and the lack of understanding of many mortgage-backed securities. (I refuse to say "lack of clarity". Those securities were very clear, they were just complicated requiring something beyond cursory examination to understand. If you bought a computer without reading the specs and it failed to do what you wanted, you would not call the computer obscure. You would call your buying process uninformed.) The combination of these two factors created a huge understatement of systemic risks throughout the financial system. That understatement lead to an over-evaluation of those securities which gave us the crisis when that stopped being the case.

Now, if instead of having a couple of very big banks, we had many small banks, the differences would have been quasi-nil. I spoke some time ago with an executive at a firm which hired loan officers. Now, when you meet a loan officer, you may feel that you are talking to a perhaps eager, but level-headed guy pretty low on the totem pole. The truth is, the best ones among them were rock stars. If you can originate enough loans, banks will offer anything to bring you on-board. That created a competition where tying compensation to repayment of the loan quasi-impossible. Because if you try to better align your loan officer's compensation to your firm's interest, he'll go find a job with another firm. And if that happens, your competitors will eat you up and you will not last long enough to see your smart long-term planning vindicated. By having more smaller firms with less market power you would have even more competition for those star underwriters further exaggerating that tendency to short-term thinking. When it comes to the wide-spread use of these over-priced securities, it does not matter whether the firms are big or small. Everyone was using them from pension funds in Sweden to the big firms on Wall Street. Breaking up Citibank into 50 small banks would have done nothing to prevent the crisis.

The truth is, it was not those big firms that were in difficulty and too big to fail. It was the entire financial services industry. And so concentrating on making sure Citibank is not "too big" or ensuring Goldman Sachs cannot topple the world economy will solve no problem. The waves of failures of hundreds of small banks would have pulled us into a Great Depression just as surely. In fact, the size of those big banks and the industry concentration allowed the government to more efficiently use its resources. When Bear Stern was failing, Ben Bernanke had their executives in his office within hours and a plan could be hammered over the week-end. Can you imagine the government having to negotiate a rescue plan for hundreds of small failing banks simultaneously? It would take months and chances are that by the time the government acted, it would be too late.